Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 13 March 2018

Budget deficits, fiscal councils and authoritarian regimes


Budget deficits are a constant temptation for politicians. If you want to cut some taxes it is politically easier to do this by borrowing than by raising other taxes or reducing spending. If the electorate were fully informed this should not be the case, but they are not fully informed. We have clear evidence that many (not all) politicians succumb to this temptation: economists call it the problem of deficit bias. Running deficits are attractive because in most cases they do no immediate harm. In the past I have likened them to drinking or eating too much: do it once and no great harm is done, but do it repeatedly and problems arise, if only because taxes have to increase to pay the interest on the mounting debt.

This point about no immediate harm is vital to understand. It means that if there is a good reason to run large deficits that increase government debt, like an economic downturn (automatic stabilisers), or fighting a deep recession (interest rate lower bound) or high return public investment projects or disasters (natural or man made), then you should do so. Like eating too much, you can always eat less later. Fear that you might not eat less later should never be a reason for not using fiscal policy to fight a recession, or undertake much needed investment. It would be like stopping Christmas because you might eat too much.

If that is all obvious to you then skip the next three paragraphs. Some MMT economists or their followers sometimes argue that deficits never matter. If monetary policy cannot control demand and inflation and fiscal policy has to do it instead, then this is correct. It is the fighting a deep recession point above. But in reality, outwith the interest rate lower bound, interest rates are used to control demand and inflation. MMT would like fiscal policy to control inflation always, in which case the deficit is whatever it needs to be to do that task, but for the moment monetary policy is used instead. That means that the need to control inflation is not a direct constraint that removes the deficit temptation for politicians.

That is why we had deficit bias in most countries before the global financial crisis, and it is why Trump is cutting taxes and raising the deficit now. To say mounting government debt as a result of deficit bias does not matter is not credible. Even if you think the higher taxes required to cover servicing higher debt has no disincentive effect, the political consequences of high taxes cannot be favourable. To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control.

I can completely understand where MMTers are coming from. We have just been through a period where politicians have pretended the deficit was all important, and this pretense has inflicted great harm. But that does not make the opposite point of view that the deficit never matters right. As so often happens, the political right have abused economics (pretending the government is like a household) for political ends, and some on the left have reacted not by pointing out what economics actually says, but by saying we need a new economics.

Fiscal councils are a vital part of combating deficit bias for many reasons.They are no longer the oddball idea that a few of us kept going on about just 15 years ago, but as this VoxEU ebook shows they are now a standard part of how fiscal policy is done in (almost?) every advanced economy. My chapter in this ebook argues that they are a necessary part of what I call the consensus assignment. In most places they work with fiscal rules rather than being a substitute for them. They are necessary because sometimes governments try a cheat fiscal rules (PFIs in the UK) and sometimes simple fiscal rules need to be broken for some of the reasons outlined earlier.

Fiscal councils are almost always advisory bodies. (Although the more politicians do the wrong thing with fiscal policy, the greater will be calls to change this.) They have no power to tell governments what to do, and their only influence comes from their ability to adequately scrutinise what the government is doing, which in turn depends on both the voice they have within the political system, their competence [1] and their independence. Establishing that, preserving that and sometimes enhancing that are a constant battle, precisely because these bodies take away the ability of politicians to pull the wool over the voters’ eyes.

Because an effective fiscal council acts as a watchdog over the decisions of finance ministers, they become vulnerable to political attack. We now have networks that can help defend them. Fiscal councils within the EU have established their own Network. In addition within the EU the new Fiscal Board has a dual role, of both being a kind of fiscal council for the European Commission, but also to act as a champion of independent, effective EU fiscal councils as Michal Horvath suggests here. It was therefore good to see this Board warn and the Network warn against moving the Danish fiscal council away from Copenhagen. The OECD also conducts valuable assessments of fiscal councils (see Spain here), although whether the OECD has the ability and agility to defend a fiscal council under attack outside the EU is less clear.

These defences are important, because it is so easy for governments to compromise fiscal councils, by denying them information and resources, or by appointing political heads. Governments that go even further and dismiss existing fiscal councils are even more worrying. The first time I became aware of what was happening in Hungary, as I relate here, was when they abolished a strong and very active fiscal council lead by George Kopits. Far worse has happened since in Hungary, but perhaps from this experience abolishing a fiscal council is a good early warning signal of authoritarian regimes. We have also seen unprecedented attacks on the CBO by Republicans in the United States. Ironically these attacks show us that fiscal councils in some cases have become, and in other cases can become, a vital part of a pluralist democracy.

[1] That competence includes understanding when high deficits are sensible and when government debt should rise. Any fiscal council which only ever advises deficits should be lower will lose any reputation for competence.














11 comments:

  1. The problem is that we produce vast persistent surplus and fiscal councils throttle access based on their arbitrary perceptions of who deserves it, using artificial scarcity of money to create scarcity where none really exists. The mainstream model assumes scarcity and imposes it by making money scarce. Meanwhile private finance supplies money from IOUs on demand for its friends.

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  2. I disagree that MMTers argue that deficits 'don't matter'. It oversimplifies what they say. They argue that deficits are nowhere near as critical or dangerous as monetarists make them out to be, and that running the public sector in an actual surplus for long periods can cause a recession due to the contraction it causes in private sector growth. But there is a recognition that high deficit spending when the economy is already growing comfortably can cause inflation and therefore needs to be stemmed.

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  3. "interest rates are used to control demand and inflation."
    But Richard Werner says there is no evidence whatsoever that they do:
    http://www.actuaries.org/LIBRARY/Presentations/2014/WERNER_Intl_Actuarial_Assoc_Pres_Forum_2014.pdf pages 9 & 10.

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  4. I'm not sure that we can say that interest rates are used to control demand and inflation. They were used to do that for the "great moderation" when we gradually transitioned from a period of high inflation and high interest rates to a state of low interest rates and low inflation. But we have used that up. We now have low interest rates, low inflation and low demand. Only if we somehow regain a state of high demand and high inflation could we go back to that interest rate based system. That isn't where we are and we need to be talking about where we are rather than "what if" scenarios. It also is far from clear to me that interest rates are ever a good way to control demand and inflation. We might be much better off keeping a zero interest rate policy from now on.

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  5. "To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control."

    The point is that monetary policy has not been effective in inflation control. Massive QE around the globe has had next to zero effect on inflation and recovery - at least, it can be said that QE has been inordinately slow in firing up the real economy. All it has served to do is engender widespread asset price inflation, sowing the seeds for the next financial debacle. Who's to say that financing deficits with central bank money creation would result in a speedier effect on the real economy - again, the least that can be said, is that it puts spending power where it is more likely to impact the real economy directly.

    Henry Rech

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  6. RE: "... That means that the need to control inflation is not a direct constraint that removes the deficit temptation for politicians. ... ..."
    • No politician will last long tolerating inflation. Inflation is uncomfortable and easily modulated. A Full Employment Fiscal Policy coupled with a Job Gty will not trigger inflation. If it does start to creep up, an across the board bump in tax rates for everyone will cool things off. This can be included in the Job Gty legislation --> say target a maximum inflation of say 4%, measured monthly, which would trigger an automatic temporary tax increase.

    RE: "... To say mounting government debt as a result of deficit bias does not matter is not credible. ... To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control. ..."
    • It certainly IS credible. The deficit AND the Federal debt don't matter at all. They don't even have to be reported. See blurb: http://mmt-inbulletpoints.blogspot.com/2017/09/im-just-responding-to-various-economic.html
    • The bond/money mix can be set aside once fiscal policy is relied upon to modulate inflation. A Job Gty as part of a Full Employment Fiscal Policy is the ultimate automatic stabilizer or "buffer stock" (See Bill Mitchell).

    RE: "... Fiscal councils ... ..."
    • Fiscal councils can certainly have a role in entities which don't issue, borrow in, and float their own currencies like EU countries, cities, towns, and individual states in the US. In the US, UK, Turkey, Canada, Japan, China (kindof), India - they have no role. A Job Gty with an inflation target, and automatic tax increase when exceeded, will suffice.

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  7. Hi Simon, thanks for your thought provoking and nuanced articles on your blog.
    Could you please elucidate (for a beginner like me) on your sentence “To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control.”
    To my simply layman mind this seems to be central crux why governments cannot simply create money (and introduces the constraint of interest repayments which leads to higher taxes) but I don’t understand why there has to be a mix of bonds and newly created money (and how that works) when introducing new money and how the ratio of these influences inflation. Could you explain what’s going on (when you have time).
    With best wishes and many thanks

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  8. In the MMT framework taxes are needed to destroy wealth and suppress aggregate demand generated by certain groups of economic agents. Why would a sane person acting in the interest of the whole society lower taxes on the richest 1% when these people are not only hoarding financial assets but also vacuuming, hoarding and destroying real resources? (this actually happens - when the state institutions have been privatised by the 1%) It is this hoarding of liquid financial assets what creates a hole in aggregate demand. This has to be filled up with either government deficit spending or (worse) with leveraging, with growing long-term indebtedness of some other social groups. I know that this story doesn't fit into a DSGE model because we have to consider multiple social classes and income distribution issues. Regarding the use of monetary policy this tool doesn't guarantee full employment (not the NAIRU - we need to keep in mind that NAIRU was estimated to be >10% in one of Central European countries). Also - monetary policy does not distinguish between the increase of the volume of short-term debt (the Keynesian "revolving fund") and the rise in long-term indebtedness especially household debt. If interest rates are low to make investment profitable this also encourages leveraged speculation on real estate. How would a fiscal council guarding low deficits help in solving these issues is not obvious.

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  9. "As so often happens, the political right have abused economics (pretending the government is like a household) for political ends, and some on the left have reacted not by pointing out what economics actually says, but by saying we need a new economics. "

    Nobody economics has been made to say what you want it to say - although its classical foundations are very clear from an ideological and philosophical point of you.

    The basic problem with New Keynesian economics is well summarised here:

    http://www.bondeconomics.com/2018/03/the-easy-way-to-deal-with-factionalism.html

    The fiscal rule is a good idea - if not an innovative one. The separation of long term capital and operational expenditure is the norm in many countries - think of Japan's FILP. In many ways we would be going in the direction of European socialism - which I think is a good thing. Maybe you would also want to consider prices and incomes policies - not a good idea if you believe in classical theory, but common features of a number of well-run economies.

    The lessons from these experiences - good and bad- are to be learned from looking at the actual experiences in these countries - not from Model.

    NK.

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    1. The second paragraph should read:

      "Nobody questions that economics has been made to say what you want it to say - although its classical foundations are very clear from an ideological point of view."

      NK.

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  10. Fiscal councils

    For a country the size of the UK I would like to see quite a large Fiscal council, at least a couple of hundred members. I would also like to see regional representation. Each member of the fiscal council would represent a specific geographic area.
    I would like to see some form of accountability of the fiscal council member. Some consultation or vote by the people of the geographic area to select their fiscal council member.

    Inevitably there would be disagreements on the fiscal council. I can easily see the fiscal council dividing between a Tight Fiscal Policy group and a Loose Fiscal Policy group. Whichever group was in the majority would have the whip hand with regards to fiscal policy. The minority group would have to wait until they could change public opinion in their direction. I would like to see the chance to change all fiscal council members every four or five years. This would be needed so public opinion was adequately reflected on the fiscal council.

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